How Crowdfunding Fills Gaps Created by the Venture Capital Industry

Editor's Note: The following comes to us from David Brown, co-founder and director of operations at Smart Money Entrepreneurs, a broker/dealer-based equity crowdfunding platform. Brown discusses gaps in the startup industry that venture capital firms helped to create, and suggests that equity crowdfunding can help fill those gaps. You can follow his firm on Twitter @SME_vc.

2013 presents more than an opportunity for small businesses and investors. In 2012, we saw the exponential growth of crowdfunding investments around the world. Never before have entrepreneurs been able to raise such a significant amount of capital to jumpstart their businesses.

People want to invest in entrepreneurs – why stop them? Individual investors are realizing the power of directly investing in startups that have a plan and a vision. That is why the global crowdfunding industry experienced a 91 percent growth in investments from 2011 to 2012. Industry analysts estimate that the industry will grow from $2.8 billion to at least $6 billion in 2013. That is $6 billion for innovation and job creation. 55 percent of that growth will take place within the U.S.

Venture capital firms, also known as VCs, have created gaps in the startup industry that venture crowdfunding can now fill. Those gaps are inefficient use of startup time, lack of startups being funded, lack of diversification in the industry, and lack of transparency in startup investments – an important issue that’s rarely mentioned.

Inefficient Use of Startup Time

Early stage startups need to spend more time building their startup, and less time searching for seed capital from a venture capital firm. Over the last 50 years, VCs have done a great job at selling their value added services, and now startups almost immediately seek VC funding when looking to grow. Unless soliciting advisement, any time spent not building a startup past the seed stage could arguably invite a lower return on invested time.

If an entrepreneur spends months capital raising from venture capitalist, they are losing time that can be spent building the company. As most entrepreneurs know, most opportunities have a limited window of time. A good article from OnStartups talks about why the VC funding process is so lengthy. Paraphrasing VCs' answer, they need time for the deal to ‘bake’ before they can invest. Well, god forbid, I may be dead by the time they decide to invest. The article then gives an interesting thought at the end, asking the reader to think about a new type of VC that drastically cuts down their due diligence time, and invests in startups. To mitigate the risk, they propose a probationary period where the VC can claw back some of their funds if the deal doesn’t turn out to be what they originally thought.

Fortunately, equity crowdfunding can cut the amount of time spent capital raising, and give entrepreneurs more time to build profitable ventures. Individual investors online won’t have the luxury of meeting the entrepreneur over several months to vet an opportunity, so an individual’s due diligence time is exponentially lower. In the UK, where equity crowdfunding is now legal on CrowdCube, an entrepreneur spoke about how crowdfunding was fueling their startup faster than VC funding. This is just one gap that has now been filled.

Lack of Startups Being Funded

The next gap to be filled is the lack of deals that get funding. Only 10 percent of ventures that apply for venture capital funding get a check. The venture capital process is stymying innovation and job growth, with 90 percent of ventures falling into the 'missed opportunity' bucket.

Let's be honest, malls filled with shops, towns filled with businesses, and businesses filled with workers are not bad ideas – even if the businesses aren't "home-runs." So, where do the other 90 percent of business go? Why can't they take a stab at "luck," as many venture capitalists accredit their success to? With venture crowdfunding, this funding gap is now filled. Entrepreneurs now have the chance to find more investors than ever before; investors who "get it," and who want to venture together. It's working already all over the world.

Lack of Diversification in The Industry

Investor risk is the sole reason the SEC and FINRA are delaying the rule making process for crowdfunding. Basic economics dictates that if you spread your portfolio across a broad range of investments, you lower your risks. Risk in the current startup industry is high, not so much because of the businesses, but because the majority of traditional funding goes towards a relatively small amount of startups. VCs lose on 75 percent of their investments. Therefore, not only are 90 percent of potentially good businesses being denied funding, but only a quarter of the 10 percent of funded ventures make out as positive investments.

Consequently, only 2.5 percent of startups that seek venture capital funding help grow our economy. That number is unacceptable. Venture crowdfunding will increase the pool of startup investors funding startups, spreading the risk of aggregate startup investments made in the industry, and increasing the percentage of successful startups that help grow our economy. Lets go from 2.5 to 25 percent in 5 years!

Lack of Transparency in Startup Investments

The final gap to be explored is the lack of transparency in startup investments. Investors usually want to know how to exit a deal (read: get their money back) in return for taking a risk. When an individual investor gives their cash to a VC to do the investing for them, they lose the direction and control over investment. When VCs invest, there are no tools employed to ensure true transparency in how the startup burns through the cash.

Investors who wanted more control over their investments, turned to online solutions like E-trade, Scottrade, and Charles Schwab. There is plethora of individual investors who invest in traditional markets, are not accredited investors, and could directly invest in startups. However, those investors won't invest unless they have a trusted source of due diligence, and they can track the progress of their investments. This gap can be filled by venture crowdfunding, and is currently being addressed by our venture crowdfunding platform Smart Money Entrepreneurs (SME). SME has created a technology solution for individual investors to track the real time progress of the startups they invest in, while giving investors clear exit options, and well-vetted investment options.

Outlook

The biggest challenge for the venture crowdfunding industry in 2013 will be to find a middle ground between funding startups, and investor protections. Once that middle ground is achieved, the exponential growth of a new investment industry is inevitable, and small businesses will continue to play a major role in the economic recovery of the nation.

- Brown manages SME administrative operations, cross-team collaboration, and marketing efforts. Prior to Smart Money Entrepreneurs, Brown was an emerging leader in public sector. He was a New York City Urban Fellow in 2009/2010.

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